Sri Lanka Plans Company Tax Cuts to Fuel Economic Growth After Civil War

By Anusha Ondaatjie and Kartik Goyal -
Nov 22, 2010

Sri Lanka said it will cut taxes on
banks and builders, adopt an inflation target and ease foreign-
exchange rules to accelerate growth and curb prices in the South
Asian nation emerging from a 26-year civil war.

President Mahinda Rajapaksa, unveiling the 2011 budget in
Colombo yesterday, announced plans to lower the value added tax
for lenders to 12 percent from 20 percent, reduce the levy on
construction companies to 12 percent and offer breaks to tea and
rubber companies. He forecast the budget deficit to narrow to
6.8 percent of gross domestic product from 8 percent in 2010.

The changes to the nation’s fiscal and monetary frameworks
mark the biggest overhaul of economic policy since Rajapaksa’s
government defeated a separatist group that had fought for
independence. The dividend from peace has already helped make
Sri Lanka’s benchmark stock-market index the world’s second-best
performer this year.

“The broader objective is better macro management after
peace returned,” said Prakriti Sofat, a Singapore-based
economist at Barclays Plc. “By inflation targeting they want to
ensure that inflation expectations are anchored, which will
benefit economic growth.”

Sri Lanka’s benchmark Colombo All-Share Index, which has
climbed more than 90 percent this year, lagging behind only
Mongolia, fell 0.8 percent to 6515.8 yesterday. The Sri Lankan
rupee was little changed and closed at 111.38 per dollar, after
rising about 3 percent since the war against the Liberation
Tigers of Tamil Eelam ended in May 2009.

Inflation Targeting

The government will allow foreign investors to buy
corporate debt in the country, let local residents purchase
shares of foreign companies and insurers will be able to invest
up to 20 percent of their “long-term fund and technical reserves”
abroad, according to technical notes in Rajapaksa’s budget
speech. The changes will “promote exports and develop local
capital markets,” according to the notes.

Before the budget statement, the Central Bank of Sri Lanka
said it plans to introduce inflation targeting in an effort to
lower long-run changes in consumer prices, joining Southeast
Asian counterparts including Indonesia, Thailand and the
Philippines.

“Both advanced as well as emerging economies have also
moved into an inflation-targeting regime in order to secure
price stability on a sustainable basis,” the central bank said
in a report on its website. “Recent achievements on the price
front have placed the monetary authorities in an advantageous
position in terms of inflation expectations.”

‘Firm Handle’

Inflation in Sri Lanka is about half the average rate of
the five years through 2009, after an expansion in farm
cultivation, following the end of the war, boosted production.
Consumer prices in the capital, Colombo, rose 6.6 percent in
October from a year earlier.

“The central bank wants to get a firm handle over
inflation and make sure that it doesn’t get out of hand,” said
Samantha Amerasinghe, a Colombo-based economist at Standard
Chartered Plc. “Given the government’s broader objective toward
sustaining growth, it’s essential that inflation remains under
control.”

Sri Lanka’s central bank said it intends to put in place
the “new monetary policy framework during the forthcoming
months.” It didn’t specify the target rate it plans to adopt.

Philippines, Thailand

The central bank in the Philippines aims to keep inflation
between 3.5 percent and 5.5 percent. Indonesia’s central bank
has a target of between 4 percent and 6 percent for 2010, while
Thailand’s central bank intends to maintain the core inflation
rate, which excludes food and fuel prices, in a range of 0.5
percent to 3 percent.

Rajapaksa’s tax reductions are aimed at boosting economic
growth, betting an increase in consumption will help increase
revenue and cut the budget shortfall. Tax collections may rise
about 20 percent to 862 billion rupees ($7.7 billion) in 2011
from the previous year, the president estimated. Spending is
projected to grow 11 percent to 1.42 trillion rupees during the
same period, he said.

The island’s $42 billion economy may grow about 8 percent
in 2011 after an estimated 7.6 percent expansion in the current
year, the central bank report showed yesterday.

Rajapaksa’s strategy finds precedence in Russia, which
credits the adoption of a 13 percent flat income-tax rate with
helping boost revenue 12-fold over eight years. In the U.S., tax
reductions during the administrations of John F. Kennedy and
Ronald Reagan might have helped bolster revenue because they
reduced relatively high marginal rates, according to the
Washington-based Tax Foundation.

By contrast, reductions from lower levels enacted by
former President George W. Bush added about $1.7 trillion to
deficits between 2001 and 2008, according to the Center on
Budget and Policy Priorities.

“Sri Lanka is embarking on a fiscal and monetary policy
aimed at faster economic growth,” said Sarath Rajapakse,
director of research at Capital Trust Securities Pvt. in Colombo.
“The expanding economy will bring in more revenue and make the
budget-deficit target achievable.”